BT: Crude price hikes affect one and all

Business Times - 22 Oct 2007

Crude price hikes affect one and all

JASON LOW takes a closer look at the importance of crude oil and its impact on the global markets today

DESPITE last week being the earnings season in the United States, much of the stock market's attention was focused on the surging crude oil prices, which breached US$90 a barrel before the weekend. Indeed, oil prices have always dominated headlines in financial reviews and market reports for the longest of time. But why is the market always so concerned about crude oil prices? What is the resulting impact of rising crude oil prices on the market?

Being the basis of the world's first trillion-dollar industry and the largest item in the balance of payments and exchanges between nations, the importance of crude oil in the world today cannot be underestimated.

What is crude oil?

To understand crude oil better, it is imperative to understand what it really constitutes. Crude oil is a naturally occurring substance found in certain rock formations in the earth. It is a dark, sticky liquid which is the source of fuel oil, petrol, jet fuel, diesel, and even plastic. Some electricity plants in the world, for instance, are powered by fuel oil. So crude oil is key in almost every industry in the world today, from medical to engineering. To truly appreciate the importance of this precious commodity, just imagine the day when all of the world's transportation systems cease to function and factories stop operating when the world has consumed its last drop of oil.

As crude oil is derived from the fossilised remains of dead plants and animals over millions of years, it is a limited resource that will eventually run out. Based on latest estimates by the International Energy Outlook 2007 reference case, the world's daily oil consumption is expected to increase from 83 million barrels per day in 2004 to 118 million barrels per day in 2030, with two-thirds of the increment projected for use in the transport sector.

Demand growth is highest in the developing world, particularly in the booming economies of China and India, and to a lesser extent in Africa and South America. Where high demand growth exists, it is primarily due to rapidly rising consumer demand for transportation via vehicles powered by internal combustion engines.

While demand for this black gold (as crude oil is commonly known) has increased significantly over the years, production has not matched this insatiable demand.

Renowned American geophysicist Marion King Hubbert predicted that future world petroleum production will inevitably peak and then decline at a rate similar to the rate of increase before the peak as these reserves are exhausted and eventually run out. This phenomenon is known as 'Hubbert's peak'. And, according to him, the actual peak has actually occurred in 1970 in the US. In other words, the rate of oil production in the US has entered a terminal decline as of 1970. And many other countries' production levels are set to follow suit in the very near future.

As for how long the crude oil in the ground will last, analysts have given wide-ranging forecasts of between 40 and 110 years. The prospect of an eventual exhaustion, coupled with the relentless increase in demand, has made oil prices very sensitive, especially to news threatening the supply of oil. For instance, concerns that a Turkish incursion into Iraq in search of Kurdish rebels could disrupt crude supplies have directly led to the recent surge of crude oil prices to record highs last week.

The importance of crude oil

Political arenas are the most common of places where the world can openly witness the massive influence of crude oil - one of the main components of the struggle in global political economy.

'Needless to say, oil-wielding countries are able to leverage on oil prices to achieve greater value in their international bargaining chip - be it social, political, economic or financial,' said He Shuhan, COO of investment education firm Farseers Pte Ltd. 'Changes in oil prices complicate the world economy and disrupt businesses when government leaders of oil-dependent countries, in response to price spikes, employ resistant policies such as import substitution which augment and de-stabilise the global economy.'

At the domestic level, rising oil prices erode profit margins for companies as these companies will inevitably incur higher operating costs due to the higher oil prices.

'Oil prices have long been seen by investors as a gauge of the profit margins of companies, especially those in the transportation and shipping industries since a huge portion of their operating expenses is spent on oil and its energy-producing by-products,' said Alvin Chia, a full-time private investor. 'Thus it is definitely not unusual for the public's attention to be turned to crude oil prices even during the earnings season as oil prices have a definite impact on the markets and investors out there are all wary about it.'

These rising oil prices also have an impact on individuals as well in the form of increasing transport costs and energy bills as seen from the latest bus-fare hikes and spike in petroleum prices in Singapore. Consequently, it directly affects consumer spending as individuals will have less cash to spend on the products and services offered by the various industries.

Thus it is evident that, contrary to the beliefs that crude oil prices will only affect big industries and conglomerates, the rippling effects of crude oil prices are far reaching and can easily affect the lifestyles of people like you and me.

Looking back at the issues discussed, it is apparent that an investor's profitability is directly affected by the state of global economy and business cycles, which, in turn, is highly influenced by price spikes of oil. The world's economy and population as of now cannot live without oil. Unless alternative energies make a breakthrough, the world will continue to live in the peril of the fast-depleting crude oil.